Discussion of Capital Market Return Expectations

Rhode Island Municipalities

January 24, 2012

Rhode Island Municipalities

Presented by:

Allan Emkin

Pension Consulting Alliance, Inc.

Background

Investment Earnings + Contributions = Benefit Payments + ExpensesInvestment Earnings + Contributions Benefit Payments + Expenses

Today’s Presentation will focus on Investment Earnings:oday s ese tat o ocus o est e t a gs

Earnings on Earnings onInvestment Earnings = Income assets (Fixed Income) + Growth assets (Equity) g ( ) ( q y)

Fixed Income returns are expected to be lower than in the past

To the extent economic growth is lower, Equity returns will be challenged to deliver at historical levels

Take-away: Long-term investors should expect lower capital market returns over the next decade than historical averages

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CHANGED INVESTMENT LANDSCAPE

Changed Investment Landscape

THE WORLD HAS CHANGED FOR LONG-TERM INVESTORS:

RECENT MARKET DYNAMICS

Factors that provided a tailwind in the past are expected to present a headwind

L I t t t i tLower Interest rate environment

Debt levels are higherGovernment: to finance operationsGovernment: to finance operations Consumer: to fund purchases of housing and consumer goods

Growing capital flows increase the potential for global capital marketGrowing capital flows increase the potential for global capital market volatility

Other influencesOther influences

Take-away: Powerful secular trends have the potential to influence the investment landscape in a negative way for the next decade

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investment landscape in a negative way for the next decade and possibly beyond

Changed Investment Landscape

LOWER INTEREST RATE ENVIRONMENTLOWER INTEREST RATE ENVIRONMENT:

Indicates that future expected returns from Fixed Income will be lower than in the pastthan in the past

Future Fixed Income market returns are relatively easy to estimate Today’s 10 year Treasury note’s Yield to Maturity is a goodToday s 10 year Treasury note s Yield-to-Maturity is a good predictor of a 10-year holding period return

Take-away: Long-term Investors can expect a 2.25 – 2.75% returnon a diversified portfolio of U.S. Fixed Income securities

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Decline in Interest Rates: Negative Real Returns

90 Day Treasury Bills Real Yield(1982‐2011)

8

10

(1982 2011)

4

6

2

4

‐2

0

‐4

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Declining Interest Rates: Fixed Income Tailwind

U.S. Fixed Income Returns and Interest Rates (1982 2011)

30

35(1982‐2011)

20

25

BC US Aggregate 12‐Month Trailing Return

10

15 Interest Rate (10‐Year US Treasury)

0

5

‐5

7

Decline in Interest Rates & Rise in Interest Rate Risk

10 Year U.S. Treasury Yield & Duration

9

1018

7

8

9

12

14

16

4

5

6

8

10

12

Years (D

uratio

eld to M

aturity

2

3

4

4

6

n)Yie

0

1

0

2

10 Year Nominal  Yield 10 Year Duration

8

Changed Investment Landscape

DEBT LEVELS ARE HIGHER:

The U S Government and the citizenry have over-extended theirThe U.S. Government and the citizenry have over-extended their debt burdens.

Debt / Borrowing can stimulate economic activity in the near-to-Debt / Borrowing can stimulate economic activity in the near tomid term

However, Debt has a costInterest (debt servicing), and ( g),Debt needs to be repaid

When debt reaches high levels it can act as a brake on economic growth

Interest payments and debt repayment can crowd out future purchases and economic projects

Take-away: Debt financing burdens point to Lower economic growth prospects and potentially lower Equity market

t

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returns

Changed Investment Landscape

ADDITIONAL FACTORS CONTRIBUTING TO LOWER ECONOMIC GROWTH PROSPECTS IN THE DEVELOPED ECONOMIES:GROWTH PROSPECTS IN THE DEVELOPED ECONOMIES:

Aging populationsAging populations

Slowing population growth

As a result Economic Growth is expected to be lower in the developed market economies

Take Away: Lower economic growth prospects in the developed markets point to lower Equity market returns

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Changed Investment Landscape

60

Median Ages

50

30

40

Years Japan

Western Europe

S

10

20

USA

World

0

Developed market economies continue to age

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Take-away: Aging population points to lower economic growth

Changed Investment Landscape

GROWING CAPITAL FLOWS INCREASE THE POTENTIAL FOR GLOBAL CAPITAL MARKET VOLATILITYGLOBAL CAPITAL MARKET VOLATILITY:

Growing global capital flows could increase the probability of tail risk events (low probability events that trigger large equity market losses)events (low probability events that trigger large equity market losses)

Greater interconnectedness of the global financial system increases the likelihood of a global financial market contagion (U S sub-primethe likelihood of a global financial market contagion (U.S. sub-prime problem)

Large trade imbalances continue to stress the global financial systemLarge trade imbalances continue to stress the global financial system

Take-away: As financial wealth becomes more equally distributed globally the potential for market volatility increases asglobally the potential for market volatility increases as various economic interests compete in the marketplace

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Equity Market: Recent Volatility

160Russell 3000 Index

Growth of U.S. Equities?

140

150

Total

110

120

130

Gro

wth

of $

100

90

100

Created with mpi Stylu

70

80

Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Aug-09

(44%) lossin 25 months

(42%) lossin 16 mths

+ ≈ (70%) cumulativelosses in last 9 years

Take Away: Large equity market declines have occurred more frequently than expected

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Equity Market Expectations

There are several structural conditions that present a headwind for future equity market return prospects

I ddi i E i k i d hIn addition, Equity markets are not priced cheapCurrent U.S. price / earnings ratio = 21.7 x

M t j it b ll k t t t d f l l ti l lMost major equity bull markets started from very low valuation levelsi.e. 1982 price / earnings ratio = 7.8 x

Take-away: Equity markets are not priced cheaply. It is unlikely that a sustainable long-term bull market for equities would start from current market valuation levelscurrent market valuation levels

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Equity Market Expectations

S&P 500 Price‐to‐Earnings (01/01/82 ‐ 01/01/12)

40

45

50

S&P 500 Price to Earnings (01/01/82  01/01/12)

25

30

35

40

Ratio

15

20

25

P/E R

0

5

10

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Equity Market Expectations

Equity Market Return Expectations are Challenged:

Over long term:

Equity Market Return =Equity Market Return = Dividend Yield of market + economic growth + p/e multiple change

Today: Div yield = 1.9% (historically low yield level)Economic Growth = 3.0% (lower growth than historic levels)p/e multiple change = 21.7 X (average p/e level – chance of p p g ( g p

future multiple expansion is not high)

Take-away: Historically low dividend yield, lower economic growth expectations and a fairly priced equity market are not predictive of strong equity market returns

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10-YEAR CAPITAL MARKET EXPECTATIONS

Expected Return Assumptions Comparison

Average not

10 Year Arithmetic Returns %

PCA  RussellEnnis Knupp Callan Cliffwater Wilshire Average

not including  

PCACash 3.00           3.40           2.75           3.00           2.50           2.50           2.9             2.8            TIPS 3.75           3.90         3.90         3.60         3.50           3.50         3.7           3.7          U.S. Core Fixed Income  3.30           4.40           4.50           3.80           3.10           4.00           3.9             4.0            Core Real Estate 7.00           6.70           6.80           7.85           8.90           6.50           7.3             7.4            Real Return 6 50 6 70 6 50 4 50 6 50 6 1 6 1Real Return 6.50           6.70         6.50         4.50           6.50         6.1           6.1          U.S. Equity  8.75           7.30           8.70           9.35           9.10           8.25           8.6             8.5            Non‐U.S. Equity 9.00           7.40           8.90           9.50           9.20           8.50           8.8             8.7            Private Equity  12.00         9.60           15.10         13.10         12.90         12.50         12.5           12.6          Inflation  2.75           2.50         2.40         2.50         2.30           2.25         2.5           2.4          

Note: Real Return for Callan and Cliffwater are Commodities

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Expected Return Assumptions Comparison

10 Y A ith ti R t %10 Year Arithmetic Returns %

C l

Average not 

i l diPCA 

Consultant Average

including  PCA

Cash 3.00           2.9               2.8            TIPS 3.75           3.7               3.7            U.S. Core Fixed Income  3.30         3.9             4.0           Core Real Estate 7.00           7.3               7.4            Real Return 6.50           6.1               6.1            U.S. Equity  8.75           8.6               8.5            Non‐U.S. Equity 9.00           8.8               8.7            P i E i 12 00 12 5 12 6Private Equity  12.00       12.5           12.6         Inflation  2.75           2.5               2.4            

PCA core fixed income assumption lower than the average

PCA inflation assumption higher that the average

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10 Year Expected Returns: Arithmetic and Geometric

Expected Avg. Arithmetic

Annual Return

Expected Geometric

(Compound) Annual Return

Cash 3.00 3.00

Treasury Infl. Protected Securities 3.75 3.60

Domestic US Fixed Income 3 30 3 20Domestic US Fixed Income 3.30 3.20

International Fixed Income 3.30 2.80Global Fixed Income 3.30 3.00

Core Real Estate 7.00 6.50Real Return 6 50 6 20Real Return 6.50 6.20

Domestic Equity 8.75 7.30International Equity 9.00 7.00

Global Equity 8.90 7.40

Hedged International Equity 8 90 7 10

A ith ti t t t i

Hedged International Equity 8.90 7.10

Private Equity/Venture Capital 12.00 8.90

Inflation 2.75 2.75

Arithmetic return – average return you can expect in any year

Geometric return – average compounded return Incorporates return volatility

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Geometric returns are lower than Arithmetic returns

Projected Public Fund 10 Year Returns

,

Return and Risk based on Wilshire’s Capital Market Assumptions and States’ Asset Allocation Policy

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Source: Wilshire Consulting - 2011 Wilshire Report on State Retirement Systems

CONCLUSION

CONCLUSION:

Powerful secular trends are likely to restrain capital market rates of return for th t d d d ibl b dthe next decade and possibly beyond

1. Long-term Investors can expect a 2.25 – 2.75% return from Fixed Income, over the next decadeover the next decade

2. Moderate economic growth prospects in the developed markets point to lower Equity market returnslower Equity market returns

3. As financial assets become more equally distributed globally (Sovereign Wealth Funds and growing middle classes in the developing counties) theWealth Funds and growing middle classes in the developing counties) the likelihood of increased market volatility increases as various economic interests compete in the marketplace (2008 and 2001)

Over the next decade long-term investors should expect lower capital market returns than historical averages

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